SEC finally responds to Chicago Fed warnings on high-frequency trades

NEW YORK--More than two years ago, the Federal Reserve Bank of Chicago was pushing the U.S. Securities and Exchange Commission (SEC) to get serious about the dangers of superfast computer-driven trading. Only now is the SEC getting around to taking a closer look at some of those issues.

Critics of the SEC say the delay is part of a pattern of inaction in dealing with the fallout from high frequency trading and shows that the regulator doesn't yet fully appreciate how fears of machine-driven market meltdowns are driving investors away from U.S. markets.

Even as the SEC gears up for a meeting on Tuesday to discuss software glitches and how to tame rapid-fire trading, the eighth public forum it has had in two years on market structure issues, regulators in Canada, Australia and Germany are moving ahead with plans to introduce speed limits to safeguard markets from the machines.

One item up for discussion is whether regulators should require trading firms and exchanges to deploy a “kill switch” so that they can quickly shut down a runaway high-speed computer program. That's one of the seven recommendations the Chicago Fed made to the SEC in its March 25, 2010, letter.

The Chicago Fed said exchanges and other trading platforms should install more risk controls, even if it slowed down trading, including a “kill switch” at the trader workstation level. “The competitive quest for greater and greater speed must be balanced with appropriate risk controls so that a clearly erroneous trade does not destabilize markets by precipitating a cascade of other trades in response,” the Chicago Fed's then Financial Markets Group Senior Vice President David Marshall said in the submission.

Less than two months later, the Dow Jones Industrials would plunge 700 points in a matter of seconds. The May 6, 2010, flash crash sparked a national debate over the merits of stock trading that takes place in fractions of a second, but it only led to modest action from the regulators.

Since then, there have been a series of smaller — though still frightening — events for investors, including the near-collapse of major market maker Knight Capital after a software glitch led to violent price swings in more than 100 stocks on August 1 this year. That problem lasted for at least half an hour, leading to questions about why a “kill switch” wasn't quickly employed.

And still the move towards reforms has been slow.

“So far, the SEC hasn't seemed to think high-frequency trading is a problem,” said Edward Kim, a former senior vice president at the Nasdaq Stock Market and now a consultant with audit firm Grant Thornton.

Kim, who testified on Sept. 7 before an SEC panel in San Francisco on the potential pitfalls of high-frequency trading, said he's seen first-hand the fallout that the flash crash has had on investor confidence. Kim noted his father was so rattled by the rapid market meltdown he subsequently sold most of his stocks.

Institutional buy-and-hold investors also remain frustrated.

Mutual fund manager O. Mason Hawkins, who met with the SEC a month after the flash crash in June 2010 to provide evidence about how rapid-fire machine trading was destabilizing the market, has the same view today, according to a representative for his firm, Southeastern Asset Management.